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Ask Farnoosh: Pay Down Student Loans or Contribute to Kid’s 529?

Chris emails: We have 3 student loans of varying interest rates (5.75%, 4.875% and 2.875%) with the largest loan at the lowest rate. We also have one child and one on the way. We want to save for their educations yet can't help feeling weird about paying for theirs before ours. We wanted your take on paying off one loan at a time and taking that payment to fund a 529 or other savings; or is it better to start with even a small contribution now? One consideration is living in South Dakota with no state income tax as an immediate incentive to do a 529.

I think you should put your financial obligations ahead of your children’s college savings in this particular case. While a 529 plan is a great college savings vehicle – and the cost of higher education shows no signs of slowing down -- paying off your existing student loans should be the priority. One recommendation I do have is that if your student loans are all private, you may want to try to consolidate them into one giant loan with a single interest rate. The benefit would be one payment each month and an easier time staying on top of the debt.

Either way, stay the course until you’re debt-free. Remember, while they carry relatively lower interest rates, student loans can balloon and turn quite ugly if you fall behind. And by letting the loans drag the harder it will be to not only save aggressively for college – but for your own retirement, as well. “While I applaud …saving for your child’s education, you should also consider the impact your current debt has on the ability to grow wealth over time,” says Heather Jarvis, a student loan expert.

And don’t feel guilty. It may seem selfish to put off your children’s college savings, but as Gerri Detweiler, credit expert at Credit.com says, “You're honoring the agreements you made when you took out these loans, and even though your kids don't know it yet, you are showing them that you are committed to getting out of debt. Once those loans are paid off, saving for their educations should feel relatively painless.”

Teri emails: I have cancer and am losing my job. Can I pay for health insurance (COBRA) by taking deductions out of my 401(k), and if so, are there penalties and tax consequences?

Dear Teri,

I’m sorry to hear about your health and can’t imagine the stress of losing your job at the same time. I’m happy you wrote in.

While I stand by many in the financial community who caution against taking early 401(k) withdrawals, if your health is not improving, the medical bills are mounting and full-time work is not in your near future, I’d say yours is an exceptional circumstance that merits an early hardship withdrawal.

The IRS defines “hardship” as “an immediate and heavy financial need of the employee.” Unreimbursed expenses related to a medical emergency like yours, for example, should more than likely qualify if your company allows for this. Further, according to the IRS, “the amount [withdrawn] must be necessary to satisfy the financial need… [including] the need of the employee's spouse or dependent.” Check with your company’s human resources department to learn more about its possible hardship withdrawal rules. The law does not require companies to provide hardship withdrawals, but many willingly do and qualifications vary.

As for penalties and tax consequences, hardship withdrawals are subject to income tax and a 10% penalty if you take them before age 59 ½. “The penalty may be waived, however, if your hardship stems from medical bills surpassing 7.5% of your adjusted gross income,” according to Avery Neumark, an employee benefits expert with Rosen Seymour Shapss Martin & Company in New York. Keep in mind that if you chose this option, you’ll need to act fast since hardship withdrawals from a 401(k) are not available after losing your job, Neumark says.

If you do become unemployed before completing a 401(k) hardship withdrawal and you still need the money, you could roll over the funds directly into a traditional IRA from which you can make early withdrawals. Again, the early distribution will face income tax. There’s also a 10% penalty, but you may qualify for an exemption if you’re out of a job and stuck with high medical expenses. The IRS website has a ton more information on this.